Path-dependent behavior and information leakage in financial markets

Alessia Testa

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    Abstract

    I develop a new mechanism that exploits the leakage of information in financial markets to deliver herding and contrarian behavior, which I label “path-dependent behavior". The mechanism is related to the role of word-of mouth communication in transmitting information about stocks among traders. In practice, this occurs via dealing interactions and a notable phenomenon called “the broker's ear". I find that, for a suitably long trading history, path-dependent behavior is more likely the better the quality of traders' private information. Herding in the direction of the true state of the world occurs almost surely for any initial beliefs, and it improves price informativeness. An external observer who under/overestimates the rate of information leakage will always over/underestimate the quality of private information. I also show that when the quality of private information is very high and the asymmetry of information between traders and market maker is pronounced, the market is expected to herd 50% of the time. Nonetheless, this has little impact on order imbalance, excluding cases exhibiting catastrophic price behaviour.
    Original languageEnglish
    Article number0
    Pages (from-to)909-949
    Number of pages41
    JournalEconomic Theory
    Volume67
    Issue number4
    Early online date1 Feb 2018
    DOIs
    Publication statusPublished - 1 Jun 2019

    Keywords

    • herding
    • contrarianism
    • broker's ear
    • information leakage
    • financial markets

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